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Profit-Maximization in Long-Run (Pure competitive Market)

11 Jul

 In Short-Run only a specific number of firms is present in an industry, each of them having fixed and unchanged plant. They can shut down in sense that they may produce zero output, but these firms don’t have enough time to sell their assets and go out of business. In Long-Run, however, firms can expand or contract their output capacity. The number of firms in an industry can increase or decrease, because they can enter or leave this industry.

 Some assumptions related to Long-Run in this article

  • Entry and exit only- Firms are able or enter industries only under long-run adjustment
  • Identical Costs- Let’s assume that all firms in this industry have identical costs curve, so it’s easier to talk about a firm, knowing that all other firms are affected by any long-run adjustments
  • Constant-cost Industry- We assume that leaving or entry of industry by a firm doesn’t affect the price, consequently the position of average-total –cost curve.

   Important Idea

  The main conclusion we should get here is that: After all long-Run adjustments are completed; product price will be equal to each firm’s minimum average cost.

  This conclusion can be proven by the following facts: each firm tries to get profit and to avoid losses and in a pure competition market firms a free to enter and to leave the industry. If the market price of a good will be higher than average total cost of it, then new firms will enter the industry, this industry expansion will create a higher supply, so that the price will fall and will get equal to initial average total cost of this good. Conversely, if price if the price initial is less than average total cost then firms of this industry will support losses. These losses will push some firms to leave the industry, so as they leave, total supply will decrease, which will make the price equal to average total cost.

Long-Run Equilibrium

 Let’s suppose that each firm produces cell phones. Average total cost for producing them is 100$. Marginal Revenue will initially be 100$. But what happens if the demand for these cell phones will increase?

The answer is quite simple, initially there will be an increase in price to (let’s suppose) 120$, because of that increase in demand, then more firms will enter the industry since there is possible to get economic profit (20$). More firms enter the industry then the supple will increase, prices decreases until the point where marginal revenue equal average-total-cost (take care amount of produced goods isn’t the same with initial one).

Constant Cost Industry- An increase in Demand

What happens if the demand of our cell phone decreases?

If the demand decreases then for a period of time marginal revenue will be less that average total cost, so that our firms will get some loss. Some firms will leave the market, so the supply will decrease. Then this supply will make the average total cost equal to marginal revenue. So again this point of intersection shows that no economic profit is made just normal one. Equilibrium price is the same, but equilibrium quantity is different (less).

Constant-Cost-Industry: A decrease in demand

Long Run Supply for a constant-Cost Industry

In our example we took a constant-cost industry (industry in which entry or exit of new firms doesn’t shift long-run ATC curve of individual firms. In this case industry’s demand for resources is small in comparison to the total demand for resources.  So that industry can expand or contract without affecting resource price and resource costs. How does the demand curve look like in a constant cost industry? Since we saw that demand change doesn’t affect the price, since it always comes back to the original value, then we may say that demand curve is perfectly elastic in constant-cost industry.

 Long-Run Supply for Increasing Cost Industry

  Most of the industries are Increasing Cost Industries, in which average total cost (ATC) moves up as the industry expands and moves downward as it contracts. In Increase cost Industries entry of new firms increases resource prices. Higher resource prices result in higher value of average total cost in long rung for our firms.

If there occurs an increase in demand for the goods of this kind of industry, then new firms will be attracted to it in order to eliminate the economic profit, as we said before more firms-higher ATC value.  For example

50000 units will be sold for 80$, 70000 for 100$ and 90000 for 120$. So if firms leave this increase cost industry then the demand declines, so does the price for goods.

Long Run Supply for an Increasing Cost Industry

Long-Run Supply for Decreasing Cost Industry

In a decreasing cost industry firm experiences a lower costs as the industry expands. An example can be industry that produces PCs. An increased demand for personal computers made new PC manufactures to enter the marker and greater increased the demand for components used to build them. An increase demand for PC’s components made producers to supply more of them and to expand factories, so that they achieved economies of scale. Supply for PCs increased more than demand, so that the price declined.

Long-Run Supply for a decreasing Cost Industry



Profit-Maximization in Short-Run (Pure competitive Market)

11 Jul

Profit maximization rule
   Since the purely competitive firm is a price-taker, then to increase its revenue in short run it can change only quantity output.  Thus it can adjust its output by changes in amount of variable resources (materials, labor) it uses. So to maximize its revenues or to minimize its losses our firm has to adjust its quantity of resources used.
   There are two ways how to calculate the level of output for which our firm, in a pure competitive market, will get highest revenues. One of the methods is to compare total revenues and total costs, and another one is to compare marginal revenues and marginal costs. By the way, these methods can be applied not just in pure competitive market but also in pure monopoly, monopolistic competitive market and oligopoly.

Total Revenue- Total Cost Approach
       Total cost increases with output, because more production require more resources, but the rate of increase in the total cost varies with the efficiency of the firm. Specifically, the cost data reflect law of diminishing returns. Initially it increases with smaller amounts but after a point total cost rise by increasing amounts. Total revenue covers all costs (including normal profit) but there isn’t an economic profit. Economists call break-even point: an output value for which a firm makes a normal profit but not an economic profit. Any output between two break-even points produces an economic profit. The firm achieves maximum profit, where the vertical distance between Total Revenue and Total Cost is greatest.

Marginal Revenue- Marginal Cost Approach
   In this approach the firm compares marginal revenue (MR) and (MC) of each successive unit of output. The firm will produce any output for which marginal revenue is greater than marginal benefit because the firm will add more revenue from selling that item than the costs of producing it.
MR=MC Rule
   In the initial stages of production, when output is relatively low then the Marginal Revenue (MR) is usually greater than Marginal Cost (MC). So it’s profitable to produce in this range of output. But with additional units of output where quantity produced is relatively high, rising marginal cost will become greater than the marginal revenue. That’s why firms will try to avoid output quantity in this range. A point, where marginal revenue equals with marginal cost, separates these two regions.  In the short run, the firm will maximize profits or minimize its loss by producing that quantity of output where marginal cost equals with marginal benefit. This profit maximizing rule is known as MR=MC Rule.
Characteristics of MR=MC rule
    There are some important features of MR=MC rule and they can be stated as follows:

  • The rule is applied only if producing is preferable to shutting down.
  • The rule of profit maximization is applied to all firms whether they are purely competitive, monopolistic, monopolistically competitive, or oligopolistic.
  • In pure competitive market our rule is transformed into P=MC, because demand faced by this seller is perfectly elastic. In this case marginal cost is equal to marginal revenue. So only in pure competitive market we may substitute P (price) instead of MR.

Profit Maximization Rule   
   How to determine the profit maximization output? It’s quite easy, all output values for which marginal revenue is greater than marginal cost add to total revenue, so the maximizing output is the last value for which marginal revenue is bigger than marginal cost. In Short Run the firm produces its goods until total revenue is greater than negative Average fixed Cost, however, if it is smaller, then it is better to shut down. Take care, “shut down” doesn’t mean to get off from market, because in short run a firm can’t leave the market.
   An example of Total Revenue and Total Cost -Quantity Demanded Graph(maximum economic profit is taken randomly, since no values are present) :
MR=MC graph

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